Income Smoothing is a management tool used by firms to portray a positive image not only to the financial statement users but also to the regulatory bodies. The management in this case may use lawful procedures to ensure that the firm pays less tax while more investors join the firm. In addition, the income smoothing tool may be used to enable the firm to acquire some external financial support for its expansion activities. This paper seeks to analyze the income smoothing practice in firms.
Is the practice ethical or not?
Income smoothing, although lawful, is unethical as it denies the external users the right to access true and fair reflection of the firm; thus influencing their decision-making process. The practice tends to distort the reporting process of the firm, and instead, provides falsehood income values to attract external investors and creditors. Although the management lawfully manipulates the accounts, the impact generated by the practice severely affects the users. It is therefore advisable for the firm to disclose its incomes fully without distortion as this will assist the users to have prudent decisions. The firm will also be able to know its actual performance on the market. Responsive measures will therefore be adopted in order to ensure that the firm improves its current status if it had previously lowered its productivity.
The income smoothing practice allows the firm to intentionally shift some of its future incomes to the present in order to improve the current value of the firm. The exercise also allows the firm to reduce its discretionary costs such as advertisement and research and development costs, to improve the earnings in the current period (Buckmaster, 2001, p.65). The income smoothing aims at distributing the income variability of a firm over the years. By this the firm is free to shift some of the incomes generated in the good periods to the bad periods. The move will not only assist the firm to cover up for the current period loss but also enable the firm to retain its image and reputation to the general public. The practice is therefore meant to ensure that the firm continues to enjoy the market benefits that it’s currently entitled to. The manipulated statements are also used by the firm to acquire loans from financial institutions at a lower interest rate.
Arguments for the income smoothing
The smoothing process enables the firm to lawfully manipulate its accounting records and reduce its liabilities. The firms, therefore, play with their income figures until they are able to avoid some tax liability. The management usually utilizes the wide internationally set accounting principles to manipulate their income revenues. The practice also enables the firm to retain its good reputation even during the economically difficult periods. As a result, the firm is always able to retain its competitiveness in the market. The income smoothing assists the firm to build a strong image to its consumers who consequently respond by developing loyalty in their consumption.
This move therefore assists the firm to improve its sales volume as consumers will certainly spread positive messages to their friends who add up to the existing customer base. The firms are also allowed to strategically place their operations such that fewer tax obligations will have to be met. For instance the firm may opt to operate in a tax-exempt trade or in the field where the government has lowered the tariffs and taxes. For this reason, a firm located in the US may seek to operate in an agricultural-related field since the government has greatly reduced tax on the agricultural imports. Since the firm operates within the principle guidelines, the firm cannot fear detection by the external auditors which the creditors may hire to analyze its creditworthiness.
Income smoothing process enables the firm to put up with the slight changes in interest rates. This is so because the fair value of a firm tends to be very sensitive to the small shocks in the markets. The firm can therefore use the practice to smooth up some of the market fluctuations which may influence its operations. The supporters of the income smoothing practice encourage it since the firm can effectively hide some of its strengths from its competitors. The competitors will only access the smoothed reports which don’t reflect the true condition of the firm. The management can also use income smoothing strategies to hedge their income risk volatility which may constantly face them in the course of operations. By so doing the firm will be able to reduce the costs which might come as a result of the market risks (Adam, 2007, p.465).
The income smoothing process enables the firm to maintain a perfect relationship with the creditors and suppliers. This is because the management can manipulate the firm’s current dues reducing them to a manageable level that can be easily accepted by the external financiers. The manipulation of such incomes within the firm can help them obtain a lower interest rate loan that is affordable to service. For the creditors and suppliers who solely depend on the financial statements provided by the firm, inaccurate decisions may be arrived at which favor the firm. The firm will therefore seek to smooth up to its incomes and expenses in order to obtain favorable deals from the external financiers. As a result the firm will be able to expand its operations since the external capital will be available for it. The suppliers will also be willing to transact with the firm due to the good image it portrays in its financial statements and reports.
Arguments against income smoothing
It is believed that the process enables the firm to hide its true image to the general public, creditors and external financiers. The practice thus translates to wrong decision-making among the concerned parties. For instance, the suppliers may decide to enter into a contract with the firm when they would not have otherwise done it when the true reflection was made in the financial reports. Indeed, many suppliers have lost their investments to such firms and therefore the practice ought to be discouraged. The financial institutions may also rely on the firm’s report in offering their financial support such as loans or overdrafts. But since the condition does not reflect the true position of the firm; they may encounter some payment difficulties once the contract has already been signed. Since the practice may further lead to lose incurrence, firms should not be allowed to exercise it at all.
The international accounting standards should therefore seek to clarify some of its principles such as revenue recognition to remove the interpretation ambiguity. The principles should also be user-friendly in order to improve the understanding ability of the users. The regulatory bodies should also aim at reducing the principles numbers in order to ease the work of the people applying them in their practices. The reduction will also relieve the huge burden that the accountants have in their career operations.
Since the firm will tend to spread its income for the better and worse years, then there is no given period that the firm’s fair value will be provided in its financial reports. The firm will thus continue operating on a false identity which may consequently lead to performance decline (Albrecht, Stice & Stice, 2007, p.198). It even becomes more difficult for the firm to identify its weaknesses as they are always covered.
The shareholders tend to suffer from the income smoothing process as the high dividends that they are supposed to get during the favorable periods are not given as they are smoothed with the unfavorable periods. The smoothing process may therefore limit wealth maximization within a firm. Income smoothing practice may also counter the usual business cycle which enhances the correlation of the firm’s performance within a given market portfolio (Riahi-Belkaoui, 2004, p.451). The correlation reduction may have an immense significance to the investors who relate the statements with the firm’s performance. The overall income smoothing practice denies the tax authorities true and accurate figures which can enable them to compute the actual tax liability of the firm. Firms will therefore tend to understate their incomes in order to lower their tax liabilities. As a result of this, the government may end up losing huge sums of money through tax avoidance practice which is encouraged by the smoothing practice (Coppel, DeSerres & Organisation for Economic Co-operation and Development, 1999, p.83).
Income smoothing although lawful is unethical as it denies the external users the right to access true and fair reflection of the firm thus influencing their decision-making process. The practice tends to distort the reporting process of the firm and instead provide falsehood income values in order to attract external investors and creditors. The income smoothing practice allows the firm to intentionally shift some of its future incomes to the present to improve the current value of the firm. The exercise also allows the firm to reduce its discretionary costs such as advertisement and research and development costs, to improve the earnings in the current period.
The income smoothing basically aims at distributing the income variability of a firm over the years. The contradiction comes in because the practice is legal; the firms are therefore not liable for damages caused by the practice. It is believed that the process enables the firm to hide its true image to the general public, creditors and external financiers. As a result the firm is always able to retain its competitiveness in the market. The income smoothing assists the firm to build a strong image to its consumers who consequently respond by developing loyalty in their consumption. Since the practice can severely affect the general public, it should be discouraged at all costs. The firms should also be held personally liable for the losses and damages incurred by the external bodies for relying on the disclosed financial statements.
Adam, A., 2007. Handbook of Asset and Liability Management: From Models to Optimal Return Strategies. New Jersey, John Wiley and Sons (Online). Web.
Albrecht, W.S., Stice, J.D & Stice, E.K., 2007. Financial Accounting. Edition 10. London, Cengage Learning (Online). Web.
Buckmaster, D., 2001. Development of the income smoothing literature, 1893-1998: a focus on the United States. New York, Emerald Group Publishing (Online). Web.
Coppel, J., DeSerres, A & Organisation for Economic Co-operation and Development. 1999. EMU: facts, challenges, and policies. Canada, OECD Publishing (Online). Web.
Riahi-Belkaoui, A., 2004. Accounting theory. London, Cengage Learning EMEA (Online). Web.